Statistics produced by Stern Stewart and the ANZ Bank on the destruction of shareholder value by New Zealand companies have attracted widespread publicity. They reinforce widespread anti-business sentiments.^[1]  One business magazine has interpreted them as a condemnation of "our scandalous management". ^[2]  It has been argued that incompetent management may be a better explanation of New Zealand's inadequate economic performance than poor public policies. These interpretations are mistaken and are unhelpful for the quality of public debate.

The problems arise not because of the statistics themselves but because of a lack of sophisticated appreciation by media commentators and others of their meaning. Consider, for example, three predictable anti-business interpretations of alternative statistical results:

• More than 50 percent of businesses destroy value - media commentators attack businesses for value destruction. None commend them for their achievements in cutting prices relative to costs, or praise the virtues of competition.
• Fifty percent of businesses underperform, or just produce the required return on capital – media commentators attack businesses for the alleged mediocrity of their performance.
• More than 50 percent of businesses create value - media commentators attack businesses for price-gouging and excessive profits, especially if they are overseas owned. Some call for greater regulation of profits, controls on overseas investment and public ownership of businesses.

All these reactions would be superficial and probably flawed. They do nothing to improve public understanding of business.

This note considers two issues:

• what do the statistics say?; and

• how should they be interpreted?

Companies raise money from shareholders and borrow money from banks and other lenders in order to fund business assets. One measure of whether companies have added value for shareholders is the difference between the current market value of those assets and the total amount of money that has been invested in those assets over the years. Stern Stewart call this statistic market value added (MVA). A second measure, economic value added (EVA), essentially reflects the difference between EVA, a company's achieved net operating profit in any given year and the net operating profit it needed to achieve in that year in order to compensate shareholders for the cost of capital.

Significant adjustments may have to be made to a company's published accounts in order to estimate MVA and EVA. For example, past write-offs and lease payments may be treated differently by different analysts. The statistics may vary because of errors or differences in judgments about the proper adjustments to make.

Stern Stewart have published MVA and EVA statistics for New Zealand's largest listed companies for at least the last three years and are an international authority on this methodology.

Stern Stewart's data (see the appendix^[3]) can be summarised as follows:

Share prices are volatile and share investments are risky. Many risks are outside the control of any firm. Examples include changes in technologies, taxes, market interest rates, exchange rates and world product prices. Firms have some ability to manage some of these risks, but they cannot eliminate all of them.^[4]

Sharemarket analysts accept the reality of business risk by analysing the performance of any one management team against more benchmarks than just the cost of capital. Another common benchmark is the performance of teams that are exposed to similar risks. One forestry company's performance would be compared to the performance of other forestry companies, for example. Such comparisons are a commonsense, if imperfect, way of abstracting from the effects of factors that are mainly outside the control of any particular firm.

It makes no sense to blame the performance of New Zealand's forestry-related firms on their management teams independently of any assessment of their performance against international forestry-related competitors.

By the same logic, it makes no sense to accuse non-forestry-related firms of poor management just because forestry has a large enough weight in the New Zealand market to drive the overall market into a negative EVA situation when world forest product prices are depressed.

In a competitive market, shareholders can only expect firms to achieve their cost of capital.^[5]  Competition from new entrants or new investment by incumbents when industry profitability is above normal levels forces down prices to end users and reduces profitability. Conversely, firms exit until industry profitability is restored when the industry as a whole is failing to cover the cost of capital.

In a steady state, the typical firm will only achieve more or less than the cost of capital by chance. Therefore the benchmark for assessing performance should be zero MVA and EVA. Abstracting from the business cycle, as many firms can be expected to achieve less than the cost of capital as exceed the cost of capital. The percentages of firms covering the cost of capital as measured by EVA in the three years of Stern Stewart data (50 percent in 2000 and 1999 and 62 percent in 1998) appear to be consistent with the zero excess profit hypothesis.

The substantial excess of measured MVA over the benchmark of zero appears to contradict the zero excess profit hypothesis. As such, it invites further inspection. One possibility is that there have been favourable economy-wide shocks prior to the last three years - leading the average company to achieve returns in excess of the cost of capital. Under this hypothesis overall MVA should be negative in some future period. A second possibility is that the statistics are flattering because of a survivorship bias. Companies that recorded negative MVAs in the past may have disproportionately dropped out the sample because they have become too small. This effect may well be significant. A third possibility is that the statistics overstate MVAs by understating invested capital.^[6]  For example, investments in reputation and market positioning may not be recorded accurately in either EVA estimates or in estimates of committed capital. A fourth possibility is that important assets of many large firms are inframarginal in an increasing cost situation. Competition only drives out excess profits at the margin. If a new entrant faces higher costs, for example because of more stringent environmental or planning legislation or because all the best locations are already taken, incumbents might be able to earn ongoing economic rents measured relative to their invested capital.

The second, third and fourth possibilities provide exceptions to the opening proposition that the benchmark for success should be zero EVA and MVA. As such they suggest reasons for caution in interpreting EVA and MVA statistics. However, they do not negate the basic insight that competition can be expected to eliminate super-normal profits in time.

Note that none of these hypotheses makes any particular assumptions about the quality of management of the average firm.

Even in the absence of competition and in the presence of severe principal/agent problems, shareholders will price the firm so that they can realistically expect to achieve required returns in future. A negative surprise will see shareholders write down the market value of the firm to a level at which future expected returns compensate for risk. Unless those preparing EVA and MVA reports write down the estimated quantum of capital employed in the business, subsequent measures of EVA and MVA will be less positive than they should be on the basis of the capital actually available to managers.

Sharemarkets with poor earnings prospects are characterised by low price-earnings multiples. They are not characterised by chronic under-performance in sharemarket index terms. This is because investors can confidently be expected to learn from their mistakes, revising their assessments of the quality of management teams and boards accordingly.

Furthermore, it is fanciful to suppose that there can be any sudden change in the quality of management amongst listed companies as a whole.

For all these reasons it is implausible that any prolonged period of poor sharemarket returns can be attributed either to a sudden downturn in the quality of management or to undue, chronic optimism about the quality of existing management.

Shareholders should be able to achieve their required returns on average as long as the managers they employ have the required competencies and their remuneration reflects their productivity. Highly competent managers can be expected to be paid more than less competent managers - but would have to earn commensurately more revenue for shareholders in order to justify their higher remuneration. There is surely a limit to the level of competence that it is economic to employ locally. What would be the point of trying to hire, say, Bill Gates, at his current salary, to come to New Zealand to run a small New Zealand computer company? Markets match horses to courses. Moreover, lack of economies of scale, an unfavourable regulatory environment or a troublesome board might prevent highly competent chief executives from achieving their full productivity. In that case such chief executives can probably be more productive elsewhere.

There is no reason to assume that highly productive managers will produce greater profits for shareholders unless they are exposing shareholders to greater risk. ^[7] Competition between management teams should ensure no free lunches for management teams, or for shareholders.

While any one firm can expect to raise market share and profitability by raising its performance, the fallacy of composition explains why this will not occur if all its competitors do the same. Competition shifts the benefits to consumers and those who have raised their marginal productivity. One athlete may increase the chance of winning a gold medal by training harder and better, but only if competitors do not follow suit.

Of course, the returns to managers also reflect the assignment of risk between managers and shareholders. Other things being equal, the remuneration of managers should be greater the more insecure and unprotected their tenure.

In the case of weak boards, existing management teams may be able, for a time, to achieve excessive rewards and tenure at the expense of shareholders. Such management teams have an obvious incentive to support measures such as restrictive company takeover regulation or limitations on foreign investment that could protect their positions. Governments that pass such regulations can expect to exacerbate any gaps between rewards and performance.

A final caveat is that productivity is a function of effort and quality. Highly able individuals can exhibit low productivity because of insufficient effort and focus.

None of these caveats alters the basic proposition that competition between management teams should ensure that their cost reflects their productivity. Any serious discussion of the quality of management in New Zealand from an international perspective should start with an analysis of rates of remuneration. Adjustments should be made for risk and effort.

Since rates of remuneration at the top levels of management in New Zealand appear to be vastly lower than in comparable countries, it seems likely that the productivity of top management teams is lower on average than elsewhere. To the degree that they are internationally mobile, this suggests that New Zealand's managers are variously making a life-style choice, accepting markedly lower risk, or are of inferior quality to their overseas counterparts. Alternatively, some may be earning relatively low incomes, despite enormous effort and being of high quality, because of immobility and low productivity. The low productivity could be caused inter alia by the lack of economies of scale or an unfavourable tax and regulatory environment. A compensating factor from a national perspective could be overseas ownership of New Zealand operations which benefit from the skills of management teams in parent companies abroad.

Another argument is that managers of some companies in New Zealand are paid badly in the sense that the performance-related element of their remuneration package is too small. Essentially the critics are saying that these companies can benefit from their advice. If so, they should prove their worth in the market for advisers.

Government policies can be expected to affect the rate of remuneration of management teams for any given level of productivity. Anti-takeover laws seem more likely to benefit lawyers, investment banks, regulators and poor management teams than shareholders. Regulations that remove privacy concerning remuneration expose top managers to envy and malice, reducing the attractiveness of envy-prone countries as places to work. This factor, in conjunction with the signalling effects of published salary rankings - most firms want employees to think they are paid above market rates, and the job of headhunters is made easier - can be expected to increase rates of remuneration in general, but not the pre-existing level of productivity. Regulations that seek to increase management liability will have similar effects. On the other hand, employment laws that raise the cost of firing insufficiently productive management teams typically benefit incumbent management teams at the expense of competing teams.

Regulations that raise the costs and risks of employing management teams without raising their productivity are like a tax on the hiring of management teams. Such regulations should reduce the demand for management teams until the (higher) productivity of the marginal surviving team balances the costs of hiring it. Regulatory taxes on management teams could have adverse implications for the choice of organisational form and the ability of firms to separate management from control, and therefore to access capital markets and achieve economies of scale.

The populist view that the shareholder value statistics that have recently been published prove that the business community at large has been destroying value out of mediocrity or incompetence is simply erroneous. The major losses in value in the Stern Stewart data relate to three companies, Air New Zealand, Carter Holt Harvey and Fletcher Challenge Forests. Other major losses were incurred by Brierley Investments following its disastrous Mount Charlotte takeover when the company became a victim of inflexible takeover laws. The statistics do not point to underperformance of the average management team.

The view that the overall performance of the New Zealand sharemarket could be improved by a general lift in the quality of management teams simply reflects the fallacy of composition. Competition would transfer the gains to consumers and to those who raised their productivity.

Criticism may fairly be directed at companies that have destroyed value through failures of corporate governance. Also, there is always scope for improving the quality of New Zealand management. No management team is perfect. Management performance is also likely to be influenced by the level and structure of remuneration. Boards have ongoing incentives to review the links between pay and performance in the company sector and to avail themselves of value-creating advice.

The conciliatory or pusillanimous strategy adopted by some of saying 'sure the business sector has blotted its copybook and must do better':

There seems to be no substitute for greater efforts by those who understand the meaning of company performance data to explain them better to those who can communicate effectively with the public at large.

The nature of much media commentary reflects widespread ignorance of the basic concepts discussed in this paper and the strength of anti-business sentiments in New Zealand. The all-too-common use of the shareholder value statistics to dismiss business criticisms of poor public policies is unhelpful to public debate.

Since around 1993, government policy drift and more recent policy reversals have pushed New Zealand towards a path of lower economic growth rather than towards a vigorous, dynamic outward-looking future. Given this outlook, some management teams can be more productive outside New Zealand and some large internationally integrated companies can benefit from relocating their head offices abroad. There is nothing inevitable about such moves, but they should be seen as rational responses to the policy environment.

Bryce Wilkinson

Capital Economics Limited

April 2000